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Instruments used for hedging exchange rate risks in the forex market, based on the practices of HSBC Brazil Final Paper International Financial Management Since Multinational Corporation’s performance is affected by exchange rate fluctuations the assessment of their vulnerability relating to unexpected developments in the foreign exchange market is one of the biggest challenges for risk management. Due to the prevailing volatility of financial markets, finding mechanisms to hedge companies against exchange rate risks when trying to achieve excess return becomes increasingly crucial.
The basic idea of hedging strategies is to compensate potential losses that may be incurred by an investment by assuming a position in a contrary or opposing market or investment. The value of the loss of one position is offset by the appreciation of the opposite position (= variation negatively correlated single positions). The decision process of the financial manager to choose which strategy suits the best to carry out hedging involves developing a financial plan for the company.
However, the knowledge about financial products offered by the banking sector and the assessment of the extent of security required, according to the given expectations are just as important for rational decision making. Given these facts, contemporary financial institutions are constantly developing new financial instruments to fulfill the needs of firms concerning planning and security. Mitigating financial risks allows companies to focus on the management of organization’s operational risk and core business.
Since foreign trade relations between Brazil and China are constantly growing[1], the purpose of this paper is to introduce some of the main instruments used to hedge exchange rate fluctuation risks based on existing practices of HSBC Brazil. With their global headquarters in London, HSBC is the second largest global banking and financial services institution. Its network consist of 7,500 offices in 87 countries and 295,995 employees offering its services throughout the world to around 95 Mio. customers. 2] Besides being a leader in Europe, the bank is continuously growing in the Asia-Pacific region, the Americas, the Middle East and Africa. “With listings on the London, Hong Kong, New York, Paris and Bermuda stock exchanges, shares in HSBC Holdings plc are held by over 221,000 shareholders. ” [3] 2011 it has been awarded by Euromoney for being the best “Global Risk Management House”. [4] Especially in the last 30 years several complex hedging instruments have been developed. Nevertheless, derivatives are currently the main instruments used in the financial market.
According to Rubinstein[5] a derivative instrument “is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties”. Lozardo[6] defines a derivative as a financial security whose price is derived from the market price of another real or financial asset. The underlying asset of derivatives includes everything from agricultural commodities to stock prices, interest rates, exchange rates, among others.
In the derivatives market, rights and obligations for future dates are traded which have none or negligible financial impact at the time the transaction is realized. Derivatives enable the exchange of financial results achieved due to index value alterations or price forecasts, in a certain period of time on a desired amount of money. The derivatives market encompasses a set of specific market segments; each one has its own logic as well as its concepts and rules, operating characteristics, pricing mechanism and negotiation methods.
According to Lozardo, these segments are divided into futures market, forwards market, swaps market and options market. The further discussion of each of the segments is beyond the scope of this assignment and can be found in other literature such as “International Corporate Finance” by Jeff Madura. Products offered by HSBC Brazil[7] Options Options, are hedging instruments used to counteract rate fluctuations on financial markets to reduce the risks of hold assets. “This financial derivative represents a contract sold by one party (option writer) to another party (option holder).
The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date)” [8]. The bank receives a soi-disant, option premium once its services for the covered deal have been enlisted. Stop-Loss-Forward A Stop Loss Forward (SWAP with limiter) is a hedge transaction whereby a company can negotiate today, a fixed price for a future purchase of a certain amount of US-Dollars.
Doing so, the company can protect itself from Dollar appreciation against the Real (Debt becomes more expensive). Simultaneously, a maximum negative adjustment is determined in case of appreciation of the Real against the Dollar. Consequently, the company knows in advance the maximal cost of the hedging contract and has therefore less unexpected deviation from its original financial plan. Export-Lock The “Export Lock” is a currency exchange instrument which pay offs fall on a future date. It is offered in two different forms: with a fixed interest rate and with allowance for exchange rate fluctuations.
In case of a fixed rate contract, the exchange rate for the future export business is predetermined. The fixation is valid for transactions which have to be settled in Dollars as well as for those which settlement is in Real. In contrast, a company that opts for a lock with exchange rate fluctuations might profit from opportunities of arbitrage. The opportunity of arbitrage arises whenever the interest rates in the domestic market are not identical to the interest rates in the foreign market.
It is also worth mentioning that this transaction does not involve the payment of any taxes in accordance with CPMF (Brazilian taxation of financial transactions) what makes the product even more attractive for potential demanders. Spot-Foreign-Exchange An instrument for the purchase or sale of foreign exchange, which facilitates the fulfillment of liabilities resulting from imports, exports, foreign remittances and more. The Spot Exchange rate is the rate of a foreign-exchange contract for immediate delivery.
Also known as “benchmark rates”, “straightforward rates” or “outright rates”, spot rates represent the price that a buyer expects to pay for a foreign currency in another currency. The company and the Bank agree on a price for settlement on the spot date (normal settlement day when the transaction is done today). The standard settlement timeframe for foreign exchange spot transactions is T + 2 days. Foreign-exchange contracts are therefore settled on the second day after the day the deal is made.
HSBC has two trading desks, one for foreign exchange and one for derivatives which handle different types of transactions. SWAP Swap in the traditional sense is also called “foreign exchange swap”. It involves the simultaneous implementation of a spot and a futures transaction in the foreign exchange market to the “price” of the swap rate (arbitrage). However, as financial innovation, swap involves the mutual use of comparative cost advantages by two contractors. If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms.
For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates. In case of HSBC, the bank serves as intermediaries and concludes separate contracts with each partner. For the risks assumed by HSBC the bank receives a risk-adjusted commission. [9] This study has attempted to provide some insight into some of the most important and most commonly used hedging strategies that can be used in the foreign exchange market on the basis of examples of different products offered by HSBC Brazil.
As previously mentioned, the big challenge for companies which are exposed to currency risks, is to find the most appropriate instrument to optimize their individual strategies in light of their investment and financing plans and their individual risk profile. Of course, the best product must not be one of the services offered by HSBC. Rational decisions rather require the consideration of all the relevant products on the market. References [1] Bundesministerium fur Bildung und Forschung http://www. kooperation-international. e/brasilien/themes/international/fub/laender/landesinformationen/ [2] “The World’s Biggest Public Companies”. Forbes. Retrieved 6 June 2011. [3] HSBC Brazil http://www. hsbc. com. br/ [4] Euromoney oficial Homepage http://www. euromoney. com/ [5] Rubinstein, Mark (1999). Rubinstein on derivatives. [6] Lozardo, Ernesto. Derivativos no Brasil Fundamentos e Praticas. Sao Paulo BM/F, 1998 [7] HSBC Brazil http://www. hsbc. com. br/ [8] Investopedia Online Encyclopedia http://www. investopedia. com/ [9] Gablers Wirtschaftslexikon http://wirtschaftslexikon. gabler. de/